Hedge funds: Just say no

Hedge funds are almost never a good investment. As a class, they underperform and overcharge.

Only 20% of funds beat their benchmarks in a given year, and of those, fewer than half outperform in two of the next three years. Over five years, only 1% manage to beat the market after fees. For example, from 2007 to 2012 (which included a bear market and a bull market), the average hedge fund lost over 13%, vs. a gain of over 8% for the S&P 500.

Performance fees encourage managers to take undue risks, and fees take the magic out of compounding. Over five years, raw performance of 10% per year comes out to about 50% in cumulative gains. Factor in 20% performance and 2% management fees each year, and the total return is roughly halved.

So what explains the explosion of assets under hedge fund management in the last two decades ($2 trillion vs. $100 billion 20 years ago)? My guess is psychology. Hedge funds are sexy, a seemingly exclusive product for those with money and connections. They are an aspirational purchase – like joining a private club, becoming a limited partner signifies that you’ve made it. Not only does it say you have money, but that you are connected and savvy enough to find an ace manager (or so you think). If something is hard to get into and expensive, it has to be good.

The outsize earnings of successful managers (which can dwarf Fortune 500 CEO salaries by orders of magnitude) should serve as a red flag, but instead they add to the aura around this asset class. It’s perverse, but as everything is disclosed, and the facts about hedge funds are out in the open, investors seem to be choosing glamour over money. This is the same lack of concern as when buying a yacht or plane instead of renting, or dropping big money on a night out. Insouciance is the entire point.

The decision to invest in a hedge fund may involve elements of gambler’s conceit, luxury spending, and social belonging. It’s not about the returns.

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Credit to Barry Ritholtz for data on hedge fund performance from a presentation at Agora Financial’s conference in Vancouver this past July, and to Simon Lack, author of The Hedge Fund Mirage.

Prime brokerage clients stand to lose assets in Lehman bust

This is why everyone needs to be extremely careful about their brokerage, banking, counterparty and business relationships. What would a bankruptcy of any of these entities do to your finances? From Bloomberg:

Lehman Won’t Return Prime-Broker Assets for `Months’ (Update2)

By Tom Cahil

Sept. 22 (Bloomberg) — Lehman Brothers Holdings Inc. will take “considerable time” before it returns assets stranded by the world’s largest bankruptcy to hundreds of hedge fund clients, according to PricewaterhouseCoopers.

“Our current view is that this process could take several months to conclude,” PwC, Lehman’s bankruptcy administrator in London, said in a statement today.

GLG Partners Inc., a $24 billion hedge fund, and CQS U.K. LLP. are among those that used Lehman as a prime broker for borrowing stock and clearing trades. They may now join a line of creditors trying to recover money after Lehman filed Chapter 11 bankruptcy on Sept. 15 listing $639 billion of assets.

“There’s a short queue to recover assets and a long one,” said Jerome Lussan, founder of Laven Partners LLP, a hedge fund consultant and investor in London. “If your hedge fund assets have been included with Lehman’s, you’re in the back of a queue that’s quite long.”

Lehman had the right to lend prime-brokerage clients’ securities as collateral in the stock-loan and repurchasing markets, PwC said. Securities used for these purposes were mingled with Lehman’s, PwC said.

“The assets, once `used,’ were no longer held for the client on a segregated basis, and as a result the client may cease to have any proprietary interest in them,” PwC said in the statement.

Margin account holders at any institution should beware. Read about SIPC and assess your risk. Is margin really worth it?

Questionable Value

Hedge funds with assets tied up with Lehman probably will have to write down the value of those assets when they report net asset values to investors or restrict redemptions, Lussan said.

“What’s the market value of, say, $100 million that’s owed to you by Lehman?” he asked. “I’d say it’s not that great, and it’s going to have to be written down.”

Any hedge fund managers who allowed Lehman to lend out their securities were asking for a world of hurt, and in my opinion, were not qualified to handle other people’s money.

SEC intends to ban short selling. Government boxcars reported in Greenwich.

Hedge fund managers said to pack dirt under fingernails, roughen hands on bricks to avoid suspicion and possible shipment to North Dakota re-education camps.

These days it seems like we are living in an Onion article (1 , 2). It would be funny if it were not the end of the world as we know it.

I’ve been a bear since spring of 2006, preparing for a depression since early 2007, and have had no illusions about the death of the idea that was America. I saw these events coming a mile away, but the speed with which they have arrived is shocking.

By edict of the Duma…

I figured that the shorting ban (WSJ article) would pop up somewhere near the midpoint of the bear market, maybe Dow 8000, but this train to Animal Farm is an express. When will they ban international money transfers? Unapproved foreign travel? Gold?

The speed with which our leaders are dropping any pretense of respect for markets just makes me that much more bearish. 8000 could be next month, not next year as I had figured. And I have to rethink my bottom target of 3500. Really, that would not be the end of the world — this market started at 800 back in 1982, and you have to remember that equity values go POOF after an economy gets as leveraged as ours is. 75% stock market drops are not black swans. They follow credit bubbles like day follows night.

Markets are so bourgeois, anyway.

The possibility of Dow zero just ticked up a standard deviation or two. What happened to the Moscow stock exchange after 1917 anyway?

The end of the stock market? Impossible, right? Well, if our Bolsheviks enact their desires to use government funds to buy all manner of securities (as the Russians are now doing), they could eventually own everything, not just the mortgage market and a huge insurer.

Buyout mania, with a twist.

If a security’s market price is $10 and the government offers $20, that is not ‘market support’, that is a buyout. Of course, there are limits to this sort of nationalization, namely the difference in scale between the Fed’s $900 billion balance sheet and the many tens of trillions of dollars in US private equity and debt instruments, so at first they will be very selective (ahem), but they do have two tools to help them work around those limits: printing presses and guns. In a few short years, when the former lose their potency, the latter can be brought to the fore.

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PS — Of course, my opinion is that this rally (futures are up 2% on top of today’s dramatic close) is just a short squeeze and dead cat bounce. The air pocket under stocks just got a whole lot bigger. 90-day T-bills last traded at 0.07%. The stall warning light is still on.

SEC determined to drive hedge funds out of US

From Bloomberg:

Sept. 17 (Bloomberg) — The U.S. Securities and Exchange Commission, responding to a market rout this week, may require hedge funds to disclose their short-sale positions and plans to subpoena the funds for their communication records.

Hedge funds and investors managing more than $100 million in securities would be “required to promptly begin public reporting of their daily short positions,” Chairman Christopher Cox said in a statement today. The enforcement division will obtain “disclosure from significant hedge funds” regarding “past trading positions in specific securities,” Cox said.

Lawmakers including U.S. Senate Banking Committee Chairman Christopher Dodd and regulators say short sellers may have contributed to a market crisis by spreading false information and using abusive tactics to attack companies. Hedge funds and other investors argue that poor business strategies are to blame, not short sellers.

“A lot of hedge funds don’t like being forced to disclose their long portfolios, so they’re really not going to like this,” said Sean O’Malley, a former SEC lawyer and now a partner at Goodwin Procter LLP in New York. “There is going to be some push back from hedge funds, but they may not get any sympathy in the current market environment.”

When people lose money they need a scapegoat, and short sellers always top the list. And when there’s a crisis, bureaucrats and politicians can’t help but make more rules, even though it was government meddling that caused the whole problem by granting bankers a blank check to blow bubbles.

The five SEC commissioners must approve the rule, which would be adopted on an emergency basis, for it to become binding. Hedge funds, which are private pools of capital whose managers participate substantially from any profits on invested money, prefer to keep their positions secret to prevent other traders from stealing their strategies.

There are all kinds of legitimate reasons for secrecy, not just to prevent copycating.

The agency’s plan to subpoena communication records will mark the second time the regulator has sent information requests to hedge funds in three months. In July, the SEC subpoenaed hedge-fund managers and Wall Street’s biggest firms seeking evidence they were manipulating shares of financial companies.

These financial companies are insolvent. No manipulation is necessary. The proof is that when Lehman sought a buyer last weekend, with the market closed, nobody offered a dime.

Morgan Stanley, the second largest U.S. securities firm, tumbled the most ever today after a government rescue of American International Group Inc. failed to ease the credit crisis. In a memo to employees, Chief Executive Officer John Mack said the management committee is “taking every step possible to stop this irresponsible action in the market.”

Morgan Stanley

“There is no rational basis for the movements in our stock,” wrote Mack, who added that he was in contact with Cox and Treasury Secretary Henry Paulson. “We’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.”

Does Mack think he is fooling anyone?

Democratic New York Senators Hillary Clinton and Charles Schumer urged the SEC today to impose a temporary ban on short- selling of all financial stocks, saying it would “help restore a measure of stability to our financial markets.”

You can always count on these two to pick up a hammer for the coffin of America.